The Structure of Board Committees

The Structure of Board Committees

Kevin D. Chen Andy Wu

Working Paper 17-032

The Structure of Board Committees

Kevin D. Chen

University of Pennsylvania

Andy Wu

Harvard Business School

Working Paper 17-032

Copyright ? 2016 by Kevin D. Chen and Andy Wu Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author.

The Structure of Board Committees

Kevin D. Chen Department of Economics University of Pennsylvania

kch@sas.upenn.edu Andy Wu

Strategy Unit, Harvard Business School Harvard University awu@hbs.edu September 2016

Abstract. We document and analyze board committee structures utilizing a novel dataset containing full board committee membership for over 6,000 firms. Board committees provide benefits (specialization, efficiency, and accountability benefits) and costs (information segregation). Consistent with these benefits and costs, we find that committee activity increases with firm size, the proportion of outside directors, board tenure and size, and public information available to outside directors. Moreover, boards allocate directors in ways to alleviate information segregation through multi-committee directors. Specifically, multicommittee directors tend to serve on related committees and be outside directors with more expertise and experience. Also, busy directors are less likely to serve on multiple committees, possibly to avoid being overloaded.

JEL Classification: G3, M4

Keywords: corporate governance, board of directors, board committees, specialization, accountability, information segregation, multi-committee directors

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1. Introduction

Despite the central role of boards in in corporate governance,1 there is relatively little understanding of the internal organization of boards, specifically the structure of board committees. Such committees are important because, as Kesner (1988) and Klein (1998) suggest, committee meetings, and not the board meetings, are where most board activity actually takes place. Adams et al. (2015) find that 52% of board activity in S&P 1500 firms takes place at the committee level after the implementation of Sarbanes-Oxley. Specific tasks that take place within board committees include both "monitoring" tasks (such as auditing and management compensation) and "advising" tasks (for example, Morgan Stanley has a technology committee that advises the board and management team on Big Data tools and systems that control stock trading).2 Understanding how board committees are structured, therefore, allows us to gain deeper insights into the role of boards and their optimal design.

We propose a framework of benefits and costs of committees that boards balance when implementing committee structures. Board committees provide three benefits. First, committees--through the process of decentralization--can allow for knowledge specialization (De Kluyver, 2009), which benefits firms because the monitoring and advising tasks of boards are complex and require firm-specific knowledge (Kim et al., 2014). Second, specialization through committees can allow for a more efficient task allocation to directors, leading to task-division efficiency. Third, committees can increase the accountability of the board to the firm by reducing individual free-riding and enabling outside directors to perform their monitoring duties more effectively through greater separation from management. Despite these benefits, there is also a cost associated with board committees: board committees can lead to information segregation for the directors not on a specific committee (Reeb and Upadhyay, 2010). In light of these tradeoffs, we then explore the concept of multi-committee directors (MCDs), directors who sit on 2 or more committees on the same board, and we propose that boards can moderate committee benefits and costs through the MCDs. We test these mechanisms by confirming hypothesized relationships between committee activity and observed firm characteristics; specifically, we document whether firms with greater potential benefits (costs) from committees have more (less) committee activity.3

We utilize a novel dataset from Equilar to examine the nature of committee structure and the allocation of directors across committees. The dataset contains complete committee membership information, including the membership of non-required committees, for directors from firms listed on the

1 Recent work has documented general characteristics of boards, such as board size, busyness, and outside vs. inside directors. See Linck et al., 2008; Boone et al., 2007; Fich and Shivdasani, 2006; Coles et al., 2008; Armstrong et al., 2014. 2 "Morgan Stanley Board Pushes Emerging Area of Tech Governance" by Kim Nash, 2015. 3 We use two difference measures of committee activity: the number of committees and the total number of committee meetings.

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Russell 3000 from 2001 to 2013. Full committee data has not been widely available (Jiraporn et al., 2009; Adams et al., 2010), especially with coverage of both required committees (audit, compensation, and nominating/corporate governance) and non-required committees (e.g., finance, technology, and strategy). Using this comprehensive panel dataset of over 6,000 unique firms, we first document the structure of board committees. Our descriptive analysis reveals that: (1) the use of certain commonly mentioned non-required committees--including finance, technology, strategy, ethics, and diversity--is relatively rare; (2) the number of board committees has been fairly stable over time; (3) the majority of directors sit on multiple committees.

Our regression analysis provides support for the theorized benefits (knowledge specialization, taskdivision efficiency, and accountability) and the cost (information segregation). Consistent with the view that committees enable knowledge specialization, we find that committee activity increases with firm size and the proportion of outside directors; larger firms and firms with more independent boards have higher benefits from specialization, because larger firms face more complex issues than smaller firms (Linck et al., 2008; Lehn et al., 2008), and outside directors face higher costs to accumulate knowledge about the firm (Kim et al., 2014).4 Next, consistent with the view that committees provide task-division efficiency and accountability benefits, we find that board size and boards where the CEO is also the chairman (CEO Duality) are positively associated with committee activity.5 Large boards incur higher costs during communication and coordination as well as higher costs from the free-riding problem (Reeb and Upadhyay, 2010), and boards where the CEO is also the chairman may have greater agency problems (Brickley et al., 1997). Furthermore, we find that the proposed benefits (knowledge specialization, task-division efficiency, and accountability) may heterogeneously affect the value of different types of committees in a specific examination of the executive and finance committees, the two most common non-required committees.

On the other hand, consistent with the view that committees can have information-segregation costs, we find that committee activity is lower when board tenure is shorter or when less public information is available to outside directors. Outside directors with shorter tenure have less firm-specific knowledge (Kim et al., 2014), resulting in greater information asymmetry between management and outside directors and greater information-segregation costs from using committees. Outside directors can likely overcome information segregation if there is more public information available.

4 Firm size is likely exogenous to the number of committees, but the proportion of outside directors may be endogenous as boards with more committees may look for more outside directors. We address this potential reverse causality issue in Section 5.1 through an exogenous shock to the number of committees to assess the extent with which boards add directors in order to staff committees. 5 We address possible endogeneity between board size and the number of committees using the exogenous shock as well.

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Boards can moderate these committee benefits and costs through the use of multi-committee directors (MCDs), directors who sit on 2 or more committees on the same board. MCDs can reduce information-segregation costs of committees when allocated properly: we find that committees related to each other, such as the audit and loan committee, are more likely to have overlaps by MCDs. Furthermore, directors with expertise and experience--as proxied by their financial expertise and tenure--are more likely to be assigned to multiple committees. However, MCDs can become overloaded if they not allocated efficiently. Prior work has shown that directors who serve on many other boards can be time-constrained (Fich and Shivdasani, 2006), and we extend that to show that the number of other board committees-- committees on the other boards that a director serves-- is negatively associated with being on multiple committees on the focal board, consistent with the view that boards assign MCDs in ways to avoid overloading directors.

Finally, we exploit the implementation of the Sarbanes-Oxley Act as a quasi-natural experiment to test the robustness of our prior findings. Our previous tests make the assumption that boards have a given size and then decide on what committees to have and how to allocate the directors to committees: our previous results might be biased if boards add directors in response to changes in committee structure. To address this issue, we look at the implementation of the Sarbanes-Oxley Act, which produced exogenous variation in the number of committees. Beginning in 2002, the major stock exchanges--at the behest of the SEC adoption of the 2002 Sarbanes-Oxley Act--mandated that firms create a governance committee.6 We examine how boards staff this additional committee. The addition of the governance committee led to an increase of 0.27 directors in board size, while it led to an increase of 1.38 in the number of MCDs.7 In other words, to staff an additional committee, boards are about 5 times more likely to assign directors to multiple committees than to add directors to the board. Thus, while we cannot rule out the possibility of reverse causality between board size and the number of committees, it is likely not of first-order importance.

The rest of the paper proceeds as follows: In Section 2, we provide background on board committees and discuss the theoretical tradeoff in structuring them. In Section 3, we describe our data and discuss our descriptive findings. In Section 4, we conduct our main multivariate tests. In Section 5, we conclude and suggest future research directions.

2. Background and Framework

6 The governance committee is also referred to as a nominating or corporate governance committee. Nominating and governance committees are often grouped together in prior literature because of their overlapping functions. The NYSE states that "listed companies must have a nominating/corporate governance committee composed entirely of independent directors" (Section 303A.04). 7 This finding is robust several years after SOX. Note that the number of MCDs is less than or equal to the board size.

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We first document the historical use of board committees and discuss prior related work. We then introduce our framework of benefits and costs for committees and the implications of multi-committee directors for that framework.

2.1 History and Background Information on Committees

Board committees have become a more regulated and formal component of the board of directors in the United States over time.8 Beginning in 1940, the Securities and Exchange Commission (SEC) recommended that firms establish audit committees comprised of outside directors (Birkett, 1986). In the 1970s, SEC adopted rules requiring firms to disclose audit committee composition (Reeb and Upadhyay, 2010). In 2002, the Sarbanes-Oxley Act (SOX) was passed, and in response, the major stock exchanges NYSE and NASDAQ mandated that firms have compensation and governance committees.9 In addition, SOX required that the audit, compensation, and governance committees be composed solely of outside directors.10 These three committees are considered the required committees. The audit committee oversees the integrity and compliance of the firm's financial reporting. The compensation committee focuses on human resource policies and procedures, most notably the compensation of top executives. The governance committee recommends new candidates for the board and other top executive positions and sets general governance procedures; directors are usually assigned to committees at the recommendation of the governance committee (De Kluyver, 2009).

Beyond the required committees, many boards implement non-required committees to focus on other issues of relevance to the board. Strategy committees and finance committees may recommend growth opportunities (internal new projects or external M&A or alliances) and recapitalization schemes to finance projects respectively. In other cases, the board may implement diversity or corporate social responsibility committees to signal commitment to social issues and lead efforts in those directions. For example, Nike implemented a corporate responsibility committee to address controversy in its use of "sweatshop" labor and other health and environmental concerns (Paine et al., 2014). It is also relatively common to include an

8 Our study includes both standing and ad hoc committees. Standing committees are formally defined committees that are used on a continual basis. Ad hoc or advisory committees are formed on a temporary basis. 9 NYSE requires an independent nominating committee. NASDAQ requires director nominees selected or recommended for board's selection by an independent nominating committee or by a majority of the independent directors. 10 An inside director is a director who is current employee at the firm. An affiliated director is a director with existing or past business relationships with the firm (e.g., consulting, legal). We define an outside director as one who is neither an affiliated nor an inside director, which is equivalent to the general definition of an independent director. We use the terms independent and outside interchangeably. For our purposes, we group affiliated directors together with inside directors.

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executive committee composed of the chair, the CEO, and a subset of officers and directors to act on behalf of the board when the full board cannot meet.11

While there are varied practices on how boards and committees interact, generally speaking, a committee is empowered to directly set firm policy, inform the board via informal knowledge sharing or formal reports, and propose actions to be executed by the full board (De Kluyver, 2009). Committees also work closely with management, directly influencing the firm. For example, in 2005, Nike's corporate responsibility committee worked with management to study the problem of overtime in factories. While the committee and management initially played a monitoring role, eventually they realized "the limits of what monitoring could accomplish" (Paine et al., 2014). Rather than monitoring the factories 24 hours a day, they instead advised management to innovate to make manufacturing processes safer and more sustainable. This anecdote reveals how committees both simultaneously monitor and advise through the firm-specific knowledge gained by working with management.

2.2 Prior Studies on Board Committees

Most studies in corporate governance focus on the board of directors as the main unit of study. The few studies on board committees have predominantly examined the effect of the characteristics of a single committee on performance. Klein (2002) examines how audit committee characteristics affect earnings management, and finds that audit committee independence is negatively related to abnormal accruals. Some studies look at committees in aggregate. Kesner (1988) examines committee composition, finding that the composition of directors that serve on committees differs from the composition of directors that do not serve on committees in occupation, type, tenure and gender. Reeb and Upadhyay (2010) examine how committees can resolve coordination problems of large boards. Other recent research uses committees as a proxy for a board's monitoring or advising ability; for example, Faleye et al. (2011) use committee assignments to proxy for "intensive monitoring," finding that boards with intensive monitoring have worse advising performance. Finally, concurrent emerging work signals a shift towards a holistic understanding of board committees. Adams et al. (2015) utilize textual analysis of proxy statements to study delegation of work to committees by corporate boards, and they conclude that "board committees are important for board functioning and can no longer be ignored."

Our work extends beyond earlier work by providing a broader framework for thinking about the trade-offs in committee structure and introduces the moderating use of the multi-committee director.

11 The need for an executive committee to meet in place of the full board of directors has decreased with more sophisticated telecommunication technology (De Kluyver, 2009)

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